What Do Banks Do?

“For much of the nineteenth century, when banks were partnerships whose owners were fully liable for their debts, it was common for banks to have equity on the order of 40 percent or even 50 percent of their total assets. Around 1900, 20–30 percent equity for banks was common in many countries. These equity levels were not mandated by any regulation. Rather, they emerged naturally in the markets in which the banks’ owners and managers, depositors, and other investors interacted. The decline that occurred subsequently in the twentieth century was closely related to governments’ needs for finance in World War I and to the development and repeated extensions of the various safety nets by which governments support the banking industry, from explicit guarantees provided by deposit insurance to the bank bailouts and implicit guarantees for too-big-to-fail banks.” — Anat Admati and Martin Hellwig, The Bankers’ New Clothes, p. 178.

We need to reconsider the relationship between banks and government.

Anat Admati and Martin Hellwig raise two important issues in their new book. The first issue is whether banks need to be levered as highly as they are. Modern banks have ratios of debt to equity that often exceed 90 percent. The second issue is the unhealthy codependence of government officials and banks, and what might be done about it.

Unfortunately, I do not think that Admati and Hellwig have addressed these issues persuasively. They rely too much on what might be termed “verbal leverage,” meaning that I found the ratio of rhetoric to evidence in their book to be too high for my taste.

I will discuss the issue of bank leverage in this essay. In a subsequent essay, I will discuss government-bank codependency.

Why Do Firms Issue Debt?

If households really prefer deposits to equity, then one must beware the unintended consequences of forcing banks to issue more equity.

Banks are financial intermediaries. In thinking about the role of financial intermediaries, I believe it is best to start with the perspective known as the Modigliani-Miller theorem.1 Franco Modigliani and Merton Miller point out that the real assets in the economy (fruit trees, oil wells, office buildings, and so on) are all owned ultimately by households. That fact is not changed by the way that financial claims are rearranged into debt and equity. As Miller was fond of putting it, “No matter how many slices you cut, it’s still the same pizza.”

What accounts for the wide variety of financial claims in the economy? As Admati and Hellwig point out, financial structure is very responsive to regulation and other incentives that come from government. However, there are also natural institutional advantages to some structures of claims.

In theory, all the financial claims in the economy could be in the form of shares of stock. In practice, we observe that most firms issue debt in addition to equity. What accounts for this? Households are not all alike in terms of their knowledge of particular industries or their tolerance for various forms of risk. As a result, what economists call “clienteles” emerge, with different preferences for various forms of financial claims.

It is very dangerous for households to hold equity in all but the most established firms. With equity finance, “insiders” are at an advantage relative to outsiders. Because managers and the board are in control of financial strategy, including the way profits are allocated to dividends and management compensation, insiders can gain at the expense of other shareholders who are less actively involved. For example, a manager could choose to sell the company to another firm at a low price, with the manager receiving a generous compensation package from the buyer.

Such conflicts exist within large, established firms too. However, for these firms there is enough at stake that shareholders will pay the legal expenses needed to keep management honest. For example, a large investor recently sued Apple, with the suit claiming that Apple should be paying out more in dividends. Regardless of the merits of the suit, it illustrates that the fiduciary management of large, public firms is subject to challenge. On the other hand, with firms of more modest size, the costs to “outside” shareholders of enforcing fiduciary responsibility on insiders can exceed the benefits. The high cost to outsiders of enforcing shareholder rights limits their willingness to hold claims in the form of equity.

With debt financing, there is less scope for the strategic behavior of insiders to exploit outsiders. As a holder of debt, you have to make sure that you can enforce limits on the firm’s risk-taking. However, as long as the firm is able to repay the debt, other forms of strategic behavior by insiders have no effect on outsiders. In this regard, the cost to debt holders of enforcing fiduciary responsibility on management is less than in the case of equity.

Suppose, for example, that a company invests in an orchard of fruit trees. The orchard costs $95,000. Next year, on average, the market value of the orchard will be $100,000, with a standard deviation of $5,000. Assuming a normal distribution, that means that 95 percent of the time the orchard’s market value next year will be between $90,000 and $110,000. About 2.5 percent of the time, the market value next year will be below $90,000, and about 2.5 percent of the time it will be above $110,000.

The company might use $85,000 in debt financing, at an interest rate of, say, 5 percent. The debt holder is very likely to receive $89,250 next year. However, there is about a 2.5 percent chance that the debt holder will not be fully repaid, and hence will receive something less. By the same token, there is close to a 98 percent chance that the debt will be repaid, meaning that the debt holder has nothing to worry about in terms of enforcement costs.

The equity holders in the orchard will put up the remaining $10,000 to buy it this year. In return, next year they will have the market value of the orchard, less the $89,250 used to pay the debt.

If you do not have the time to continuously follow the progress of the fruit orchard, including strategic behavior by insiders, then you would rather hold the debt than the equity. For an outsider, holding debt reduces the cost of monitoring the asset and policing the behavior of the managers. In my view, that is why debt claims are so prevalent in business.

How Banks Transform Debt

Banks tend to hold medium-term debt claims. In turn, they issue two important types of claims on their own assets. One claim is equity in the bank; the other claims are deposits. As a household, you hold a bank deposit that you can withdraw at any time. This ability to use the funds on deposit at any time is highly desirable to households.

In our example, if the household were to buy the debt of the fruit orchard, the household would be stuck without use of the funds for a year, until the debt is repaid. The bank, by holding a diversified portfolio of debt and having a diversified set of depositors, expects to be able to meet immediate demands for funds on a daily basis, even though its own assets are of longer duration.

Assume that the bank has a 10 percent equity-to-asset value ratio. That means that it funds its $85,000 loan to the orchard by issuing $8,500 in stock and raising $76,500 in deposits.

In short, our simple financial sector has the following financial claims:

$10,000 equity in the fruit orchard, held primarily by managers and other insiders

$85,000 debt issued by the fruit orchard, held by banks (note that households hold none of this debt directly)

$8,500 equity issued by banks

$76,500 in deposits issued by banks

What Hellwig and Admati want to see is banks issuing much more equity to fund the debt that they hold. (They suggest 20 or 30 percent equity, compared to less than 10 percent today.) Certainly, this would reduce the chances of the banks experiencing insolvency or illiquidity.

But remember Modigliani-Miller. Who owns the financial claims issued by banks? Ultimately, it is households. In our example, it is households that have the $10,000 equity in the fruit orchard, the $76,500 in deposits, and the $8,500 equity in banks. (Of course, different households will hold different shares of these financial claims. Many households will hold neither equity in the fruit orchard nor equity in the banks.)

The fiduciary management of large, public firms is subject to challenge.

If you force banks to issue 30 percent equity in order to hold the debt issued by the fruit orchard, then you are forcing households to own $25,500 in bank equity and only $59,500 in bank deposits. Households will feel worse off in two ways. First, their bank equity will not be as liquid as were their bank deposits. Second, their bank equity will increase the extent to which households must be concerned with possible conflicts of interest with bank management as described above, because households are “outsiders” while management consists of “insiders.”

If households really prefer deposits to equity, then one must beware the unintended consequences of forcing banks to issue more equity. For example, the managers of the fruit orchard might find it profitable to attempt to issue financial claims that work more like deposits. However, the fruit orchard is not as well diversified as the bank, so the overall financial sector may become both less efficient and riskier.

Admati and Hellwig would regard deposits issued by the fruit orchard as “shadow banking,” for which their solution is stronger regulation. However, one can always wave one’s hands and call for stronger regulation, as if it could be brought about easily and costlessly. Given that, in practice, regulation is difficult and costly, this sort of hand-waving is not sufficient to justify their proposed rearrangement of the financial system.

Let me hasten to add that there is a lot to be said for rearranging the financial system. What should be considered is the way that government enters the picture, particularly with deposit insurance and preferential treatment for various lenders and borrowers. That will be the subject of a follow-up essay.

Arnold Kling is a member of the Financial Markets Working Group at the Mercatus Center of George Mason University. He blogs here.